Compare swap transactions with outright (forward) transactions.
The idea
An FX swap is a single transaction made of two opposite exchanges of the same notional of currency on two different value dates, with both rates fixed at the outset. The commonest form buys a currency spot and sells it forward, or the reverse. An outright forward is a single purchase or sale for delivery on one future date, so it leaves the holder with an open position in the currency. The two legs of a swap offset each other's exposure to the spot rate. What remains is the cost or gain from the difference between the two rates, the forward points, which reflect the interest rate differential. Swaps are used to fund or roll positions and to shift a settlement date. Outrights are used to hedge or take a view on a single future flow. Watch which side of the dealer's bid-ask applies on each leg.
Formulas
Net cost of an FX swap that sells a currency spot and buys it back forward
swap cost = N × (F − S)
- N
- the notional, in units of the currency swapped
- F
- the forward rate on the far leg, quote currency per unit of the swapped currency
- S
- the spot rate on the near leg, quoted the same way
The cost or gain is the forward points times the notional, set by the interest differential, not by where spot goes. With a dealer's quote, each leg uses the side adverse to the client: buy at the ask, sell at the bid.
A practice question
Which statement correctly defines a foreign exchange swap (as opposed to an outright forward)?
- An exchange of floating-rate interest payments in one currency for fixed-rate payments in anotherWhy not: Describes a cross-currency interest rate swap; an FX swap is two exchanges of the same currency amount on different dates.
- A single forward purchase of one currency against another, settled at one future dateWhy not: Describes an outright forward, which is one-sided and leaves a net open position.
- A purchase and a sale of the same currency amount for two value dates, both rates agreed at the outset - correct
- An option to exchange two currencies at a fixed rate on or before a given dateWhy not: Describes a currency option; a swap is an obligation on both legs.
An FX swap pairs two opposite exchanges (typically spot against forward) of the same notional in a single deal. An outright forward is one exchange on one date.
A harder one
A company holding EUR 10 million needs USD for three months. It sells EUR 10 million spot at 1.0840 and agrees to buy EUR 10 million back three months forward at 1.0872 (USD per EUR; ignore bid-ask spreads). What is the net USD cost of the swap, that is, the USD paid at the forward date less the USD received at spot?
- USD 32,000 - correct
- USD 3,200Why not: Scales the forward points incorrectly by a factor of ten (0.00032 instead of 0.0032 per EUR).
- A gain of USD 32,000Why not: Wrong sign; the company pays more USD to buy the euros back than it received selling them.
- USD 10,872,000Why not: Reports the full USD paid at the forward date without netting the USD received at spot.
The company receives 10,000,000 x 1.0840 = USD 10,840,000 now and pays 10,000,000 x 1.0872 = USD 10,872,000 later. The net cost, USD 32,000, equals the forward points times the notional.
The hardest tier
A corporate client executes a GBP 10 million FX swap with its bank: it buys GBP spot and sells GBP six months forward. The bank quotes spot GBP/USD 1.2650/1.2654 and six-month forward 1.2615/1.2624 (USD per GBP). What is the net USD cash cost to the client, that is, USD paid at spot less USD received at the forward date?
- USD 30,000Why not: Uses the forward ask for the forward sale; the client sells GBP forward at the bank's bid, 1.2615.
- A gain of USD 39,000Why not: Sign error: the client pays more USD buying GBP spot than it gets selling GBP forward.
- USD 39,000 - correct
- USD 390,000Why not: Decimal slip: 0.0039 per GBP times 10 million is 39,000, not 390,000.
The client buys GBP at the spot ask (1.2654) paying USD 12,654,000 and sells GBP forward at the bank's bid (1.2615) receiving USD 12,615,000. The net cost is USD 39,000; each leg uses the side that is adverse to the client.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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